Economic activity has at its centerpiece the buyer-seller transaction for all goods and services produced and consumed in the market economy. It is the fundamental mechanism that allocates resources to producers and output to consumers. The operation of the buyer-seller mechanism can and often is a critical determinant of economic efficiency and when operated properly, will substantially enhance market performance.
Through history, there have been many different approaches adopted to bringing buyers and sellers together, each with the key objective of permitting transactions at or as close as possible to the “market” price of the goods satisfying the desires of both buyers and sellers. By definition, the market price is the price (in given currency terms) that a fully educated market, given full access will transact select goods. Discovery of the market price can only be accomplished by permitting full access to the transaction by essentially all potential buyers and sellers and allowing expression of each party's desires. However, the buyer-seller transaction must be structured to operate at very low costs—or it will distort the market price of goods with artificially high transaction costs. Thus, the two keys to effective buyer/seller transactions—full access of expression and knowledge coupled with low transaction costs—can be and are often conflicting, necessitating trade-offs between trading efficiency and market knowledge.
One well-known and particularly successful buyer-seller transaction system is known as the “open outcry auction”. This involves a process wherein buyers and sellers collect in one location and brokers present prices for select goods to the group, via simple vocal offerings. This approach has been used for almost all kinds of goods, but is particularly useful where there are no established trading locations or markets for the selected items. It is the dominant trading forum for exotic items such as rare pieces of art and the like. Although successful in bringing interested parties to the transaction, the overall process can be very expensive, adding significantly to the market-distorting transaction costs.
Open outcry auction techniques, modified over time, have also found successful application in many trading activities, including the buying and selling of farm produce and livestock, commodities contracts, futures contracts on a variety of items and—particularly germane to the preferred embodiment of the present invention—fixed income securities. Many of these trading activities focus on the buying and selling of essentially fungible items, that is, items that are without meaningful differentiation from like items on the market. For example, a bushel of wheat for February delivery is considered for sale and delivery at a price independent, of its source. Similarly, a 30-year U.S. Treasury bond paying a coupon rate of 6.75% and having an August 1996 issue date is indistinguishable from one owned by another investor. Accordingly, the price at which buyers are willing to pay and sellers are willing to accept defines the market price of all 30-year U.S. Treasury bonds of that same vintage, allowing open outcry auction trading that is transparent as to its sources.
The fixed income securities issued by the United States government are known as U.S. Treasuries. These instruments typically span maturities of 13 to 52 weeks (T-bills), one to ten years (notes), and up to 30 years (Bonds). T-Bills are pure discount securities having no coupons. Almost all other Treasuries having longer terms are coupon notes or bonds, with a defined interest payment cycle of semi-annual payments to the holder. An additional and more recent type of Treasury security provides for inflation indexed payments.
Although treasuries are used exclusively in the following discussions, the principles of the present invention may be applied to other types of assets, including securities, financial instruments, commodities, and their derivatives without departing from the inventive concepts.
New Treasury securities are auctioned by the U.S. government at pre-established auction dates. The auction prices for newly issued Treasuries having a face value with a set coupon rate defines the Treasuries' yields when issued. After the auction, the Treasuries enter the secondary market and are traded typically “over the counter,” i.e., without a defined exchange. As inflation expectations and supply and demand conditions change, the prices of recently auctioned Treasuries fluctuate on the secondary market. The new prices are reflected by competing bid and offer prices communicated among institutions, banks, brokers, and dealers in the secondary market.
The newly auctioned securities are traded with and in conjunction with the securities issued in earlier auctions. In this context, some securities are traded more often than others and are called the “actives”; the actives usually correspond to the recently issued securities as opposed to the older securities in the market. Indeed, some older securities are infrequently traded, resulting in an illiquid market that may or may not reflect the market—determined interest rate for the more current securities at the same maturity length.
Accordingly, the very size and diversity of the Treasury market requires a high level of sophistication by market participants in the bidding, offering, buying, and selling transactions involving these securities. The very complexity associated with the transaction and the scale of trading undertaken by banks, brokers, dealers, and institutional participants necessitates a rigidly structured approach to trading.
In the past, open outcry auction bond brokering has served its customers well, providing efficient executions at nearly accurate market pricing. The open outcry auction applied to bond trading was implemented by a broker working with a collection of customers to create and manage a market. Typically, customer representatives—for both buyers and sellers—would congregate at a common location (e.g., a single room) and communicate with each other to develop pricing and confirm transactions. This process involved representatives expressing various bid and offer prices for the fixed income security at select volumes (i.e., how many million dollars of bonds at a given maturity). This expression took the form of the loud oral “cry” of a customer-proposed bid or offer and the coordination with the fellow representatives regarding the extraction of complimentary positions—until a transaction match was made and a deal done. This “trade capture” process relies on after-the-fact reporting of what just transpired through the oral outcry trade.
Recently, the trade capture process was performed by designated clerks inputting data into electronic input devices. An input clerk would attempt to interpret the open outcry of many individual brokers simultaneously, making verbally known the trading instructions of their customers. The quality of the data capture was a function of the interpretive skill of the input clerk, and the volume and the volatility of customer orders. A significant drawback to this type of auction data capture process is the difficulty in discerning the distinct trading instructions verbalized in rapid succession during a quickly moving market, so that an accurate sequence of data can be captured.
The many permutations of this process will be discussed in detail below. At this juncture, suffice to say that, at lower volumes of transactions existing at the time of its development, and the lack of suitable alternatives, the open outcry auction process remained the dominant trading mechanism for decades. However successful, this approach was not perfect. Indeed, in recent years, some of the problems in an open outcry auction forum have been amplified by the vastly increased level of trading now undertaken in the fixed income field. Generally, difficulties would occur by the injection of trader personalities into the open outcry auction process. For example, a loud, highly vocal representative may in fact dominate trading—and transaction flow—even though the representative may only represent a smaller and less critical collection of customers. Although such aggressive actions at open outcry auction may be beneficial to those particular customers in the short run, overall, such dominance of the trading can and will distort pricing away from the actual market and leave some buyers and sellers unsatisfied.
Other problems exist in open outcry auctions that retard efficient trading. The speed at which trading flows and the oral nature of the auction process injects a potential for human error that often translates into many millions of dollars committed to trades unrelated to customer objectives. On some occasions, the broker is left at the end of each trading day with a reconciliation process that may, under certain market conditions, wipe out all associated profit from that day's trading. Also, customers may quickly change direction regarding the trading, based on new information available to the market. Shifting position or backing out of a previously committed transaction on very short notice is often very difficult in the traditional open outcry process.
There have been many past efforts to incorporate computers into trading support for select assets and financial instruments, including automating the auction process through systems that control auction protocols. Indeed, almost all trading today involves some computer support, from simple information delivery to sophisticated trading systems that automate transactions at select criteria. However, these systems have not significantly impacted the issues presented relating to satisfying the complex desires of buyers and sellers in completing a transaction as they relate to open outcry auction and traditional trading in the fixed income field. It was with this understanding of the problems with certain trading processes involving the buyer and the seller that formed the impetus for the present invention.